What is a Debt Fund
A debt fund is an investment pool, such as a mutual fund or an exchange-traded fund, in which the core holdings include fixed income investments. A debt fund can invest in short or long-term bonds, securitized products, Money Market instruments or floating rate debt. On average, expense ratios on debt funds are lower than those attached to equity funds because overall management costs are lower.
Often called credit funds or fixed income funds, debt funds belong to the category of fixed income assets. These low-risk vehicles are usually sought after by investors looking to preserve capital and/or make low-risk income distributions.
Key points to remember
- A debt fund is a mutual fund, exchange-traded fund (ETF), or other pooled investment offering whose underlying investments contain primarily fixed-income investments.
- Fees on debt funds are lower than those associated with equity funds because their management costs are inherently lower.
- Investors interested in debt fund options can choose between passive and active products.
Debt fund risk
Debt funds can invest in a wide range of securities, with varying levels of associated risk. US government debt is generally considered the least risky. The risk profile of corporate debt issued by companies as part of their capital structures is generally classified according to the credit rating.
Investment grade debt is issued by companies with a stable outlook and high credit quality. High yield debt, which is primarily issued by lower credit quality companies with potential emerging growth prospects, offers higher returns, as well as higher forward risk. Other categories of debt include developed market debt and emerging market debt.
Investment in a debt fund
Investors can choose from a wide range of low-risk debt fund options, in passive and active products.
Some of the largest and most actively traded passive bond investment funds seek to track major bond benchmarks, including the Bloomberg US Aggregate Bond Index and the ICE US Treasury Core Bond Index. Passive ETFs tracking these indices include:
iShares Core US Aggregate Bond ETF
The iShares Core US Aggregate Bond ETF (AGG) is a passively managed index replication fund that tracks the Bloomberg US Aggregate Bond Index. The fund has a net expense ratio of 0.03%. Its 5-year average annual return as of August 4, 2022 is 0.83%.
iShares US Treasury Bond ETF
The iShares US Treasury Bond ETF (GOVT) is a passively managed index replication fund that tracks the ICE US Treasury Core Bond Index. It has a net expense ratio of 0.05% and its 5-year average annual return to August 4, 2022 is 0.61%.
The debt fund market also includes a wide range of active managers, who seek to outperform debt fund indices such as the Bloomberg US Aggregate Bond Index and the ICE US Treasury Core Bond Index.
The First Trust Tactical High Yield ETF (HYLS) is an example of an actively managed loan fund that invests for income and capital appreciation. Its 5-year NAV yield as of August 4, 2022 is 0.89%. Although the fund has not outperformed the selected index year to date, it is one of the best performing funds in the US high yield bond universe.
Overall, investors in debt funds need to understand the performance metrics that are used as performance indicators. Since debt funds involve the generation of income, the funds may pay scheduled monthly or quarterly dividends. Total return calculations take income payouts into account, while general return calculations do not.
Global Debt Funds
Countries issue debt in various forms to support their government fiscal policies. In the United States, government-issued debt is generally considered the least risky fixed income investment in the market.
US debt funds
The US government issues a wide range of investment securities. These securities can be invested directly or investors can choose to invest in diversified debt funds that include these securities. BlackRock’s iShares is one of the market’s leading managers for indexed US government debt fund ETFs.
US corporate debt funds are generally segregated based on the credit quality of the issuing company. US companies have some of the highest credit ratings in the world, which puts US loan funds in high demand.
Global Debt Funds
Many countries offer debt investments to support government fiscal policies. The risks and returns of public debt funds vary depending on a country’s political and economic environment. Like stocks, global corporate bond funds can be separated by developed and emerging market indices. Credit ratings are assigned to both government and corporate bonds, using globally standardized credit rating analysis.
Although debt funds are comparatively lower risk than equity funds, investors should be aware of interest rate risk.